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A look at Cyprus' decision to tax depositors

Sunday - 3/17/2013, 8:24pm EDT

SARAH DiLORENZO
AP Business Writer

PARIS (AP) -- People with bank accounts in Cyprus were shocked Saturday to learn that as part of an agreement reached with international creditors the government has imposed a tax on all deposits to help bail out the nation and its banks. Here's a look at the tax, which can be as high as 9.9 percent, and the problems it may pose.

HEY, HOW CAN THEY DO THAT?

As one of 17 nations that use the euro currency, Cyprus can to raise or lower taxes whenever it wants. Early Saturday, it secured a EUR10 billion ($13 billion) bailout from its European partners and the International Monetary Fund to save the banking sector and avoid bankruptcy. In return, the island nation has imposed the new tax, among other moves. It isn't the first time that a eurozone nation has raised taxes to cope with mounting debt and to prop up struggling banks. Residents of Greece, Portugal and Ireland -- all bailout recipients -- have seen their tax bills skyrocket in recent years as those countries tried to reduce their debts. But Cyprus is charting new ground here, and there could be legal -- and political -- challenges.

AND HOW EXACTLY WILL IT WORK?

Banks have already acted to seal off the amount of the levy -- a 6.75 percent tax on deposits under EUR100,000 and 9.9 percent on those above -- so depositors can't access it. Bank customers still can draw on the rest of their funds via ATM machines this weekend, although banks that usually open on Saturdays had limited hours. No international transfers will be able to go through until Tuesday, since Monday is a holiday. Cyprus' parliament is expected to meet Sunday to pass the required legislation. The deal also needs the approval of several eurozone parliaments; it's unclear how fast they can act and what will happen to bank deposits in the meantime.

HAS THIS EVER HAPPENED BEFORE?

So far in the euro crisis, depositors have been protected. But European countries have taxed bank deposits before. In the 1990s, Italy levied a tax on every bank account to stave off the collapse of its lire currency. The rate, however, was miniscule -- 0.06 percent -- compared to what Cyprus is enacting. Iceland -- another island with an outsized financial sector, although worse weather -- also relied on depositors to prop up its banks. When the crisis hit there in 2008, Iceland protected its domestic deposits but reneged on deposit insurance for overseas, Internet-based accounts held by British and Dutch. Those two governments stepped in to help their citizens to the tune of $5 billion. The U.K. and the Netherlands sued Iceland unsuccessfully in a European court to get their money back, but Iceland has nevertheless started to repay some of that money.

European officials are promising this Cyprus is a unique case, and they are right in one aspect: Cypriot banks are overwhelmingly funded by deposits, not bondholders. So it wouldn't have been very fruitful to go after bondholders.

WHO IS AFFECTED?

All people with money in Cypriot banks -- except those with money in Greek branches, which will be sold to Greek banks. EU and IMF creditors clearly wanted to protect struggling Greece, but perhaps also saw that Greece is the most likely place in the eurozone for a bank run. Protecting depositors there minimizes that possibility. Of the more than EUR68 billion on deposit in Cypriot banks, foreigners hold about 40 percent -- and most of those are Russians. Cyprus could have only gone after non-EU depositors, but it may have been hard to distinguish between Cypriot and Russian savers, said Jacob Kirkegaard, senior fellow at the Peterson Institute for International Economics in Washington. That is because many Russians have dual citizenship and many Russian businesses are registered on the island. Kirkegaard said Cypriots may paradoxically welcome this measure since the government just managed to widen its tax base to include a lot of Russians; the taxes levied in Greece, Portugal and Ireland were for residents alone to shoulder.

WHY DID CYPRUS NEED A BAILOUT?

Cyprus built its economy in recent years by becoming a financial center, much the way Ireland and Iceland before it did. Its banks offered Internet accounts to foreigners, were renowned for their service, provided substantial privacy to clients and had very low taxes. It worked so well that Cyprus' banking industry ballooned to nearly eight times the country's gross domestic product at the height of the boom. In December, it was still more than seven times Cyprus' EUR17.5 billion GDP. Russians -- looking for warmer climes, lower tax rates and shared culture in the form of Orthodox Christianity -- are thought to hold the majority of those accounts, with about EUR20 billion in the island's banks.